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The divergence analysis

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Despite all the market knowledge, we are still so far away from asking very basic questions about what makes it work. Market divergence, in generic terms, means the difference between the returns of two sector peers, between two sector indices, or inter-market difference. We have occasionally talked about divergence today, we look at the comprehensively.

We took the Indian sectoral indices and benchmarked it versus the CNX 100. Why did we take CNX100? It is a broad market index and, hence, the least volatile, compared to other sectoral indices. Why were we interested to compare sector returns with the broad market index? This was because we wanted to understand which sector outperformed and by how much. So, guess which sector delivered the highest return against the CNX100, starting 2005 till the end of 2011? Compared to the CNX100, BSECG (capital goods) delivered 435 per cent in 2008, while the worst during the period, compared to CNX100, was BSE Realty (-225 per cent).

 We gave a visual to the data and the shocking figures stared us in the face. If you were invested starting 2005 till 2008, you had the possibility to capture 435 per cent more compared to the CNX100. This meant about 145 per cent annually more than the CNX100. The same investor also had a choice of underperforming the CNX100 by 140 per cent, if he/she chose to stay allocated in BSE power stocks. Assuming there were liquid futures in sector indices with long-term maturity, this divergence was around 600 per cent for the respective period. A shocking 200 per cent annualised long-short strategy.

Do investors understand such divergences? Are our systems capable to identify and anticipate such large moves? The visual also proves this was not a one-time opportunity. It happened in 2008 and then again in 2011.

Now, as the visual suggests, we have a large divergence unfolding between the negative outliers (BSE realty and BSE power) and retracing positive outliers (BSE oil and BSE CG). There is continued outperformance on BSE FMCG, and (health care). While BSE SC (small cap), BSE metals are witnessing continued underperformance versus the CNX100.

Now that we have the visual, we understand divergence related multi-month opportunities and we can see trends. The next step would be to anticipate these trends. One simple way to anticipate is looking at outliers. The further the worst performer goes, the more likely it is to reverse, be it an outperformer or an underperformer.

Orpheus rankings are designed not only to identify outliers, but also establish cycles that can anticipate trends. Performance can be witnessed in various ways, not only as a relative ratio series but also as relative ranking cycles.

BSE power and BSE realty remain potential outperformers against the CNX 100, while BSE oil, capital goods, auto and consumer durables remain potential underperformers versus the CNX 100. Relative performance might need some effort to grasp, but this is the only way to visualise, comprehend divergence and understand the market opportunities.


 

The author is CMT and co-founder, Orpheus CAPITALS, a global alternative research firm

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